Stag Hunt and The Money Problem

If I were any good at writing book reviews, this post would tell you all about Morgan Ricks' new book "The Money Problem", and would explain why I think it's a very good book. [Disclaimer: I was paid to fly down to Nashville for a couple of days to help Morgan with his first draft.]

But I'm really bad at writing book reviews, so I'm going to write this post instead. Maybe "reflection" would be the right word?

Stag Hunt is a two-person symmetric game with two Nash Equilibria: a bad equilibrium (hunt hare); and a good equilibrium (hunt stag). Each can catch a hare by himself, but it takes both players to catch a stag. Half a stag is better than a whole hare. If he expects the other player to hunt hare, it will be individually rational for each to hunt hare too. And if he expects the other to hunt stag, it will be individually rational to join him in hunting stag. [I'm self-plagiarising off my old post.]

We can easily generalise Stag Hunt into a multiplayer symmetric game with a continuous strategy space. The representative agent chooses his own action Y as a function of his expectation Ye of others' actions. In Stag Hunt, his reaction function has strong strategic complementarity (a slope greater than one) over some range between the two Nash Equilibria. Like this:

The equilibrium in the middle is an "unstable" equilibrium (in the old-fashioned sense), and so deserves to be ignored. It's not a "learnable" equilibrium, for any reasonable learning mechanism. People can learn the other two equilibria, even if they don't know exactly where they are.

If you are a macroeconomist, who wants to explain why bad things (recessions) happen, without any obvious cause, Stag Hunt is immediately attractive. Because if you have a game with two equilibria, anything whatsoever that causes people to change their expectations can cause the economy to flip from one equilibrium to the other. And it is not irrational (though it may be non-rational) for people to change their expectations, precisely because those changes in expectations can be self-fulfilling. (Roger Farmer's macroeconomics is sorta like Stag Hunt, except Roger likes to build models with a continuum of equilibria, not just two.)

But Stag Hunt applies in particular to liquidity.

The amount I am willing to pay for an asset depends on my expectation of how quickly and easily I can sell it again for a price close to what I paid. I would immediately buy your used car for anything up to $1,000 if I expected that everyone else would do the same. Because I could immediately sell it again and get my money back if I decided I didn't want to keep it. In the extreme case, if it's more liquid than any other asset, and I can store it fairly easily and know it won't depreciate too much, I might buy your car even if I couldn't drive and knew I had no use for it at all. Just like the $20 notes I hold in my pocket. And everyone else might do the same.

Morgan tells us that sociologist Robert Merton used bank runs as an example of a self-fulfilling prophecy back in 1948. And the same idea is in Bagehot. It goes back before the Diamond Dybvig model.

Now when I define "bank", I mean a financial intermediary whose liabilities are used as media of exchange. And the Stag Hunt game certainly applies to banks defined in my narrow sense. If I expect others to do the same, I will run to convert my chequing account balance into currency, because even if I know for certain that the bank is 100% solvent and will eventually let me do so, the $1,000 in my chequing account is a lot less liquid if the bank suspends convertibility even temporarily.

But the exact same argument applies to any financial intermediary that borrows short and lends long, even if it is not a "bank" in my strict sense.

And there doesn't even need to be any intermediary at all. The same argument can apply to a financial market, if liquidity begets liquidity to a big enough extent, it can become a Stag Hunt game where changes in market liquidity are a self-fulfilling prophecy.

A "panic" is when we flip from the good equilibrium to the bad equilibrium in the Stag Hunt game, so assets that used to be liquid become less liquid.

I'm a monetarist, in a fundamentalist sort of sense. I see recessions as declines in the volume of monetary exchange caused by an excess demand for the medium of exchange. But there are two ways we can get an excess demand: a fall in supply; an increase in demand. And one way we can get an increased demand for the medium of exchange is if the supply of close substitutes falls (or if assets that used to be close substitutes suddenly become less close substitutes). Morgan possibly won't want to follow me in this bit, because unlike me he does not see the salience of the medium of exchange, and wants a broader definition of "money" to include things that I would call "substitutes for money". But this is how I would fit his perspective into my perspective:

A Stag Hunt panic caused the assets that are highly liquid and close substitutes for the medium of exchange to become a less liquid and less close substitutes for the medium of exchange. It also reduced the supply of those assets. That in turn increased the demand for the medium of exchange. (If the supply of Pepsi falls, or if they change the recipe so it tastes worse and less like Coke, the demand for Coke increases). The central bank and the commercial banks that produce the medium of exchange failed to increase the supply of medium of exchange sufficiently to compensate. That caused an excess demand for the medium of exchange. That caused a reduction in the volume of monetary exchange for all goods. We call that a "recession".

But a lot of Morgan's book is about how to panic-proof the financial system. The old policy was to try to "panic-proof" banks in my narrow sense of "banks". Morgan says that's not enough. He wants to cast his net a lot wider, and panic-proof all short-term (less than 12 months?) financial assets that correspond to his very broad definition of "money". I'm not sure I want to follow him there, but that's another story.

And I take back all the nasty things I have ever said about lawyers and economics. Morgan is a lawyer who has actually read economics and actually talked to economists and has gotten his head around it as least as well as economists have. And he's worked both sides of the financial regulation fence. So he's worth listening to.

Thanks Morgan. Yes, it got better, but the draft was already pretty good.

One *could* say that, but it would totally miss the point about the qualitative difference between the medium of exchange and all other assets that are bought and sold for that medium of exchange. ;-) We even *define* the liquidity of those other assets in terms of how easily they can be bought or sold for the medium of exchange. The winner of the liquidity race is qualitatively different from the second or third place finishers, no matter how close behind they are.

There are *two* ways an individual can get more MoE: 1. buy more MoE (sell more other things); 2. sell less MoE (buy less other things). You need someone else's agreement to use the first way (and if everyone else is trying to do the same thing you won't get it, because trade is voluntary). Nobody else can prevent an individual using that second way; he just does it. And when everybody does it we get a recession, because it's individually rational and possible but collectively irrational and impossible, for a given stock of MoE.

You're of course right that there's a qualitative difference between MOE and money substitutes (cash equivalents), but for some purposes we can group them together. One of the arguments of the book is that it's dangerous to ignore the creation of money substitutes when designing the overall monetary framework. We have done so to our detriment...

Morgan: I think I would agree with you there. But either we panic-proof those money-substitutes (your approach), or we design a (narrow sense) monetary system that works even if those money-substitutes have a panic. I think I prefer the second way, which does not exclude the possibility we might want to do both..

In that post Nick states 'But if we start asking why prices are slow to adjust, that same model starts to look a bit more like Stag Hunt. Maybe each firm would cut its price, if all the other firms cut theirs too; but it won't be the first to cut. If each thought the others would halve their prices, each would halve its price too. But everybody hunts hare, because if you go out to hunt stag, and nobody else shows up, you catch nothing.'.

Why wouldn't a firm be better off cutting prices even if no-one else did ? If there is an assumption that the elasticities are such that this is never optimal, and being the sole price-cutter would be like being the sole stag hunter , then what is the thinking behind this assumption ?

(Actually I have a second question: Is it the intuition that "the macroeconomic model is Prisoners' Dilemma in quantity-space, given prices, but is Stag Hunt in price-space" that drives the shape of the red line in the chart in this post? The more people expect other others to lower their prices the more they are likely to do so themselves and take the economy to the stag equilibrium?)

Short term debt runs, equity doesn't. Creating money substitutes with runnable debt is very dangerous. Even with all the financial regulation we have in Canada, our bank stocks still have high expected returns. The market sees how risky our banks are, perhaps our regulators should pay attention too.

If I thought a monetary policy rule (base money policy) could reliably neutralize the macro effects of a money-substitute panic, I would agree with you. (And I'd probably be a free banking advocate.) But this is why I'm not a market monetarist.

To echo you, this doesn't exclude the possibility we might want to do both.

"Why wouldn't a firm be better off cutting prices even if no-one else did ? If there is an assumption that the elasticities are such that this is never optimal, and being the sole price-cutter would be like being the sole stag hunter , then what is the thinking behind this assumption ?"

If I rig the elasticities right I can get a stag hunt in P-space, even if individual prices are perfectly flexible. But it takes a bit of rigging to make it work. But with small menu costs, we can get stag hunt in P-space for more reasonable assumptions about elasticities.

But this post (unlike the previous) is more about Y space and liquidity space. I'm just (implicitly) assuming sticky P here.

Avon: "Short term debt runs, equity doesn't."

I wonder if that's totally right. It would be strange if there were some magic duration such that runs were possible for shorter but not for longer durations. The value of any asset depends on its expected liquidity, and if expected liquidity drops, and the price drops (and rate of return rises) maybe only the buy-and-hold people would own it, which reduces the number of potential buyers, which reduces liquidity. The multiple equilibria with on-the-run vs off-the-run bonds comes to mind. The first is more liquid simple because it's more liquid, even though they have identical fundamentals.

"A Stag Hunt panic caused the assets that are highly liquid and close substitutes for the medium of exchange to become a less liquid and less close substitutes for the medium of exchange."

There should exist a word other than "liquid" for this situation. These assets are not illiquid in the usual sense of the word, in which for example a house is illiquid, i.e. difficult and costly to sell for cash. They can still be sold easily and instantly, especially in modern electronic markets. The problem is that in the bad equilibrium their market price collapses, triggering mass insolvency.

What distinguishes such mass insolvency is that the equilibrium can (in principle) be flipped back by government intervention. However, this is not the only kind of situation in which that's the case, and one can find examples of firms and industries bankrupted by very different mechanisms that could still be in principle restored to solvency with a bailout. Yet it's only the Diamond-Dybvig mass insolvency that gets to be excused from this damnable designation and misleadingly presented as mere "illiquidity."

Of course, one can argue (not unreasonably) that Diamond-Dybvig mass insolvency is a very special case, in which the cost-benefit calculus is uniquely in favor of a bailout. That's not a question I'd want to open here; I'm merely pointing out that the talk about "liquidity" is obscuring what's really going on.

Vladimir: Put "price" on the vertical axis and "expected time till sale" on the horizontal. I can sell my used car immediately for $200 at the wreckers, so that's the intercept. But if I advertise it, and wait months for the rare buyer who wants a car exactly like mine, I could maybe get $2,000. The shape of that curve tells us the liquidity. If I had a more common car, like a Honda Civic, that curve would be a lot flatter.

And if banks had a clause which said "we reserve the right to suspend convertibility if we run out of currency" we could still get runs even in technically solvent banks. People know they can wait, but don't want to wait.

"It would be strange if there were some magic duration such that runs were possible for shorter but not for longer durations."

The difference between debt and equity is not one of term, but in the fundamental nature of the legal claims they bestow. When your debt is due and the creditors decide to collect rather than roll over because they doubt your solvency, this kicks off a race to collect because the claims are paid on a first-come-first-serve basis. This is because of the basic contractual and legal nature of debt: it imposes a fixed obligation, which must be paid the moment it's due and the creditor shows up to collect, or otherwise bankruptcy kicks in, in which case the creditors for all remaining unpaid debt take a haircut.

In contrast, equity imposes no fixed obligation. In only grants voting rights in running the business and stipulates that if any benefits are bestowed on shareholders, they must be given in proportion to their share of equity. Share prices adjust immediately to whatever is the expected future flow of these benefits. If there are bad news, stock price falls accordingly, and shareholders may race to sell, but even totally collapsing share price can't trigger insolvency, because there is no fixed obligation to shareholders. The company simply continues business as usual, now with diminished prospects of future profits, and it can go insolvent only if its business fails in some way independent of what happens with its shares on the market.

(In general, I'm inclined to view debt as a barbarous relic, and equity as a strictly superior way of financing.)

Re: the "time to sale vs. price" curve slope as the measure of liquidity, that's exactly what I have in mind. But what does this curve look like for long-term securities whose value collapses in a Diamond-Dybvig run? Absent a bailout that restores the equilibrium, it's not like "illiquid" parties could expect to sell them for their high pre-run prices if they only spent some more time and effort on sale. Rather, per EMH, their expected future price is nothing but their low collapsed price.

Truly illiquid assets are those that require a cumbersome search and bargaining process to establish a price; that's what gives rise (heh, in both senses) to your car time-price curve. Whereas the assets that collapsed in a run already have their price precisely discovered by the rapid and merciless operation of EMH-driven financial markets.

The market of course signals this in another way as well: if you don't have cash to pay a debt that is due right now, but you have a house, you're illiquid but in no big trouble, since private parties will be glad to lend you money against the house, valued by the price it would be expected to achieve after a lengthy sale. You're therefore clearly solvent. The same is not true if instead of a house you have securities that just collapsed in a panic.

Vladimir: "...this kicks off a race to collect because the claims are paid on a first-come-first-serve basis..."

Good point. The "rush for the exits".

"Truly illiquid assets are those that require a cumbersome search and bargaining process to establish a price; that's what gives rise (heh, in both senses) to your car time-price curve."

OK, that's part of it, but there's also simply waiting. If you look on Kijiji for a very specific type of car (93-97 Mazda MX6, with V6 engine, manual tranny, little rust, not modified, reasonably close to Ottawa) there are very few if any that meet that description. So you wait for the right seller. And it's the same for the seller, who must either price very low to sell quickly to someone who really wanted something else, or price high and simply wait. A lot of search is simply waiting around. It's not costly, unless you need cash now to buy something else.

Avon: Yep. That is an important example, and shows it definitely makes a difference. And if the payment system freezes up, so that an asset that was once a medium of exchange is no longer a medium of exchange, then we definitely have a problem that fits exactly with my view of recessions.

But still I wonder: is there any sharp dividing line between "short" and "long" assets, where one can run and the other can't, or is it just a difference in degree? Looking at my diagram, if I slowly twisted the reaction function clockwise (as the asset got longer and longer) there would be a point past which there was only one equilibrium.

It might not matter that much in practice, but I want to get my head clearer on this.

I can't trade my stocks at yesterday's prices. With debt financing, during a run money leaves the bank. It's like there is a super drain and the bank can't stop it. With equity the bank doesn't have to pay anyone - nothing leaves the bank. A long asset (loan) that fails to pay doesn't create a cascade. The bank just loses shareholder money. If banks have more equity they become less risky so the chance of a run on remaining debt becomes less likely. When I have to keep entering the repo market every night to refinance a 30 loan, that's risky. That's the reason why Canadian banks stocks have such high expected returns.

Nick, what's interesting is that there is a kind of phase transition that happens at the very short end of the curve. Jeremy Stein and others have written about this (see fig 1.6 on p. 45 of the book). I argue that this moneyness premium is integral to the banking stag hunt. Reasonable people can disagree ...

Avon: I get what you are saying, and see the point. But think about the medium of exchange for a minute. If I go to a country where everyone else uses gold, I will use gold too, because it is easier to buy and sell things for gold than silver. But if I go to another country where everyone uses silver, I will too. There is very strong strategic complementarity in trading volume, (a trading volume multiplier, so that volume begets volume) even though there is no default risk with either gold or silver, and neither has a price that is more fixed than the other. Couldn't something like that happen with (say) shares too? If I want to hold an asset that I might want to sell quickly without moving the market, I will look for a share that has high trading volume. But then lots of other short-term holders will do the same, which increases the trading volume still more.

No, not the kink, but the very existence of the curve. Greenwood, Hanson & Stein took longer-term Treasury yields and extrapolated what short-term Treasury yields should be. Actual short-term yields are strikingly lower than the extrapolation would predict. They conclude that this deviation reflects "a money-like premium on short-term T-bills, above and beyond the liquidity and safety premia embedded in longer term Treasury yields." I'm ok with calling this curve "liquidity premium" but in reality it has little to do with "liquidity."

I know I won't convince anyone here, but I think this whole approach is a mistake. It's not that these kinds of liquidity equilibria don't exist or are irrelevant, but I think solving this problem is similar to trying to safeguard the economy by increasing bank capital -- an okay idea, but very far removed from most proximate cause of recessions. And yes, this is because I don't agree that the MOE function of money is what matters when it comes to nominal macro frictions. I think it's about sticky prices, and prices are about the MOA, and sometimes this difference matters. I think everyone could have all the media of exchange they could ever want, with near zero convenience yield on any particular financial asset (but still no pure barter) in a Woodfordian cashless society, but still experience a nominal recession if the price level wants to fall but doesn't fall flexibly and freely. And I think the price level could want to fall with no current exchange scarcity, it would simply mean some expected future convenience yield that was previously discount in the MOA has disappeared (bc the CB reaction function changed) or the demand for real risk adjusted returns on government debt decreased without accommodation by the CB or fiscal authority.

Morgan: Ah! I misunderstood you. Yes, the curve itself makes sense to me. It suggests that the risk of runs (or the magnitude of a run if one occurs) decreases as you move along the curve. No sharp cutoff, just a fade-out.

I didn't mention the MoA function, and sticky prices, but perhaps I should have. It's implicit. Morgan mentions the importance of money substitutes having little price variability relative to the MoA.

Did you ever see one of my posts where I argue that the Woodfordian "cashless" economy is not in fact cashless? Each agent has a chequing account at the central bank, which can have either a positive or negative balance, which pays a rate of interest set by the central bank? And he buys goods using cheques drawn on that account? But because all agents are identical, whenever he spends $100 he always receives $100 at exactly the same time. And the central bank sets the net balance on chequing accounts at $0.

The fact that they keep their cash in a shoebox at the central bank, rather than in their pockets, doesn't make any difference.

Making banks run proof is easy. Irving Fisher and the Chicago lot explained how to do it in the 1930s. Milton Friedman explained in his book “A Program for Monetary Stability” (2nd half of Ch3). Lawrence Kotlikoff has explained. John Cochrane has explained here:

http://www.hoover.org/news/daily-report/150171

Run proofing can be done by having entities or bank subsidiaries which lend funded just by shares or relatively long term bonds, not by runable stuff like deposits. As Avon Barksdale said above, “Short term debt runs, equity doesn't.”

I didn't mention the MoA function, and sticky prices, but perhaps I should have. It's implicit. Morgan mentions the importance of money substitutes having little price variability relative to the MoA.

I don't know if it's really implicit in on important sense. I am arguing that liquidity equilibria are mostly like bank failures or even just sunspot equilibria. Their macroeconomic consequences can be almost entirely muted with a CB/fiscal reaction function that successfully targets a price level. And I think the US CB in 08 made its biggest mistakes excessively focusing on liquidity in the same way it made mistakes excessively focusing on trying to save institution by institution: bailing water, ignoring the leak. And to me that mistaken focus continues today, with all these resources and brainpower devoted to dealing with every possible liquidity run or banking entanglement, when they are the least efficient and least proximate sources of the bigger problem. I see liquidity runs as neither necessary nor sufficient for a nominal crunch, and whether you agree often comes down to how you think about the importance of the MOE vs. MOA function. It isn't enough to say that the connection is implicit. Still, I am not trying to criticize creative attempts to improve the equilibria space for liquidity in particular, they are okay as it goes, but like bank capital regulation which is also okay as it goes, they are very easy to get wrong which is a big obstacle when you think the reward for success isn't what people seem to think it is. So the MOE vs. MOA conversation is not just academic.

Did you ever see one of my posts where I argue that the Woodfordian "cashless" economy is not in fact cashless?

I'm not sure I agree with this characterization of Woodford's cashless model, but I definitely agree it is not well specified. Just to be clear, we are talking about the cashless model not some cashless limit. I don't believe this version uses the CB balance for settlement in any way, nor does it specify anything at all about these balances. They are really nothing but zero period bonds, government liabilities, despite their seeming to be no bonds in the model. This leads some people like McCallum to question whether the CB liabilities would even remain the unit of account, and Buiter called it phlogiston. But I think the problem is different. Woodford describes a payment system settled by private technologies (not CB balances) like an accounting system of exchange, without any involvement of these CB balances (again, cashless model not at the cashless limit of his cash model). But you don't get to just vaguely describe such a thing without explaining exactly why you still have a price level and not pure barter. He simply assumes that for some reason there is a technology that allows perfect liquidity and Walrasian-like private settlement but still somehow (implicitly) prevents the kind of pure barter that would solve any nominal friction in the first place.

But my take is that it would be possible for Woodford to better specify this world. We can imagine a payment system that requires an MOA but has almost no exchange constraints. I go to the store and can pay $10 for toothpaste but can pay with any financial asset I own, while Alphago's daughter on my phone quickly conducts a multi-party settlement such that the storekeeper gets whatever financial asset she chooses. I don't have reduce my money holdings to purchases anything, I trade my Valeant stock, a third party trades his AAA corporate bonds to the storeowner and I get the toothpaste. But I can't simply trade anything for anything, because we haven't yet successfully turned all the sticky prices like labor rentals and consumer goods into financial assets. If we did, the prices would no longer be sticky anyway, so the problem would already be solved. And I still need a price level, although Alphago II does not, because it is useful coordinating mechanism for my inferior brain.

Vladimir:
"The market of course signals this in another way as well: if you don't have cash to pay a debt that is due right now, but you have a house, you're illiquid but in no big trouble, since private parties will be glad to lend you money against the house, valued by the price it would be expected to achieve after a lengthy sale. You're therefore clearly solvent. The same is not true if instead of a house you have securities that just collapsed in a panic."

Compare this to a bank run. If only 10%, say, of the deposits are being withdrawn, of course the bank will be able to take out wholesale funding and make good on those deposits. In fact, it would normally already have that wholesale funding in place. The same is true if that debt that you owe amounts to 10% of the value of the house. In a bank run, however, substantially all of your deposits are being withdrawn. No real-world bank can survive that, no matter how good its assets. And if your debt amounted to 100% of the value of your house, you will be filing for bankruptcy, not taking out a mortgage, because no-one will lend you 100% of the value of your house.

In the traditional bank run, the assets of the bank are not collapsing in a panic. In fact those assets generally don't trade at all, they are business loans or mortgages that are being held to maturity, for a traditional bank. The point of the bank run is that it happens primarily because depositors are worried about other depositors withdrawing, not because depositors are worried about the assets that the bank holds.

Even in the non-traditional bank run involving, say, ABCP conduits, the assets held by those conduits are being traded only because the conduits are trying to liquidate. In normal circumstances, they are extremely illiquid assets that almost never trade, they are most certainly not traded in an electronic market or anything close.

Nick/dlr: Isn't the function of money that's relevant in these situations the store of value function, not the MoE or even the MoA?

In the modern economy, do we ever really have a situation where there's not enough MoE to support the existing volume of transactions? I would say people try to spend less than they earn in order to increase their stock of the store of value, not to ensure that they have enough MoE to make their day-to-day transactions.

The money-substitutes like treasury bills or commercial paper or money market funds are all substitutes for the store of value function, not for the MoE or MoA functions. Electronic payments are not settled in treasury bills or even demand deposits, they are only settled by transfer of central bank reserves, no? And prices are not quoted in terms of treasury bills or commercial paper either.

When there is a run, people are trying to convert from one store of value to another, but in a modern economy, they are almost certainly not trying to convert into central bank money per se. They may be trying to move demand deposits from one bank to another, or sell money market funds and buy treasuries, for example. This should not necessarily require the net creation of central bank money. In the latter case, for example, the central bank should be lending the money market funds money secured by their assets, while at the same time selling treasuries to meet the demand and mop up the money it just lent.

Avon:
"Look at the different between the dot com crash and the 2007/2008 financial crisis. One way financed by equity and one by debt. One froze the payment system the other didn't ."

But was the reason equity vs debt, or simply that the large banks important to the payment system happened to have much larger exposures to the securities affected by the mortgage crisis, than they did to the securities affected by the dot com crash?

dlr: Suppose we set aside what Woodford actually said. Suppose we just assume that he "meant" to say this: "Barter is impossible for all the standard reasons, and you can only buy and sell things for money. Money consists of chequing accounts at the central bank, which pay a rate of interest set by the central bank. It's both MoE and MoA. Each agent can have a positive or negative balance, but the central bank sets the aggregate net balance to zero, so seigniorage is also zero."

Wouldn't that be a lot simpler? The rest of his model then works exactly the same as he says it does.

Compare this to a bank run. If only 10%, say, of the deposits are being withdrawn, of course the bank will be able to take out wholesale funding and make good on those deposits. In fact, it would normally already have that wholesale funding in place. The same is true if that debt that you owe amounts to 10% of the value of the house. In a bank run, however, substantially all of your deposits are being withdrawn. No real-world bank can survive that, no matter how good its assets.

I think you're not pointing at the real problem here. Consider a hypothetical situation where there's a run on a solvent bank whose market share is very small. Assume also (for now) that all assets are easily tradable. Since the bank is solvent, it means that the value of its assets is higher than the sum of its liabilities, so the assets can be sold off to cover all withdrawals, up to and including 100% of the deposits, leaving a remainder that can be given back to the shareholders. Everyone is happy and no cascade of bad events takes place.

So why aren't bank runs harmless in reality? It's because above we assumed that: (1) only a single bank is affected by the run, and (2) this bank has a negligible market share. These assumptions mean -- and this is the key -- that the sale of long-term assets doesn't move the market. In reality, a panic means a simultaneous run on all banks, and even a single large bank can move the market significantly by itself. Therefore, as all of these long-term assets are dumped on the market, their value collapses due to sheer supply -- and suddenly everyone who holds them has the "assets" side of his balance sheet devastated, possibly triggering insolvency. That's the Diamond-Dybvig switch to a bad equilibrium.

In practice, of course, there are also the problems you mention: not all long-term assets are easily tradable, and you can't borrow against the full market value of your illiquid assets. But suppose that banks are regulated so that they're allowed to balance their zero-term deposits only with fully liquid and tradable long-term instruments (e.g. by having all the loans they issue securitized so they can sell them off on Wall Street with a mouse click at any moment). This would eliminate the problems you mention, and make a hypothetical run on a single small bank harmless, but it wouldn't eliminate the systemic risk of bank runs at all. The scenario from the above paragraph could still happen as described.

In contrast, if instead of a bank that balances zero-term deposits with long-term loans we have a bond fund, whose assets are also long-term but which is equity-financed and has no zero-term liabilities, there is no event that would trigger an emergency sale of assets. (Since you don't have to scramble to compensate the shareholders if there is bad news and it turns out that the fund is worth less than previously assumed.)

Another thing to add is that thanks to the government deposit insurance (another standard but misleading term, I might add), in Anglospheric jurisdictions it's been a very long time since the last real bank run panics, i.e. those whose epicenter was in actual banks working with small depositors.

However, the above "bank run" reasoning applies to any maturity-mismatched parties, i.e. those whose balance sheet features long-term assets and short-term liabilities. (These are commonly referred to as the "shadow banking system.") Specifically, during the 2007/2008 crisis, my understanding is that lots of insolvent parties found themselves in a situation where their long-term assets (such as the infamous mortgage-backed securities) collapsed not just because it turned out that the underlying loans were higher-risk than assumed, but because they were being dumped on the marked massively in a scramble for liquidity (while short-term loans were being called in by creditors who no longer trusted their borrowers enough to roll over).

In conjection with the book Morgan Ricks' book, take a look at "How Big Banks Fail and What to Do about It" by Darrell Duffie. Notice that Duffie recommends Ricks' book. "The Bankers’ New Clothes" by Anat Admati and Martin Hellwig is another great book on these subjects.

There are a lot of excellent ideas out there about how to deal with these problems. The central message is to stop regulating the assets and start focussing on the liabilities. Bank runs are about the liabilities, not the assets. In the end, banks need to issue more capital! But of course government likes things the way they are - a cozy relationship that subsidizes debt to buy votes.

Just today, our new government is promoting a new Canadian Infrastructure Bank "to provide low-cost financing for new infrastructure projects.
The federal government can use its strong credit rating and lending authority to make it easier and more affordable for municipalities to build the projects their communities need." Another nice fat debt subsidy. I love it when government talks about "low-cost financing" - guess who's holding the risk below market prices....?

I think the difference between debt and equity here is that equity can run in a medium-of-account sense from uncertain value: my groceries aren't priced in shares of RBC, so if I fear RBC shares will be less valuable in the future I want to "run for the exit" now, even if I know I can sell them instantly at any moment.

Additionally, the set of assets that are "close substitutes" for money depends on the planned purpose. If I intend to go on vacation in 16 months, then for that purpose cash and a 1-year GIC (purchased today) would be identical from a liquidity perspective. That correspondence breaks down for buying today's lunch.

From the standpoint of the financial crisis, I think the initial shock was a medium-of-account shock: financial institutions were surprised to learn that the value of their mortgage-backed securities was possibly less than they believed. That then spread to a medium-of-exchange crisis (and "bank run"), leading to a freeze-up in the general credit markets.

Wouldn't that be a lot simpler? The rest of his model then works exactly the same as he says it does.

I can see why you'd say simpler, but I don't think that matters. Woodford doesn't explicitly eliminate an MOE in his models, I agree. You can think of his models as credit-as-MOE or as (perhaps zeroed out) CB balances as MOE. And you can argue the latter is the "simplest" interpretation of his cashless economy. But that's only because he wasn't trying to solve the problem you are worried about, and his model could just as well apply to my world above (with the CB balances having zero role in the settlement system whether zeroed or not, and acting instead only as zero period government liabilities and the MOA) without changing anything else. And he is pretty clear in other places that this is actually what he thinks.

He thought it was sufficient to combat those who believed that we need MOE demand modeled explicitly (or perhaps a ton of hard thinking about liquidity equilibria for MOE substitutes) if he ensured that there was no marginal convenience yield and that transactional frictions were all but eliminated both today and tomorrow. And I agree. I don't think it matters at all that there is still an MOE lurking in the "simpler" interpretation of cashless Woodford, exactly because I can describe a genuinely MOE-less (or, at least, a model where so many financial assets count as the MOE no reasonable person could still claim MOE supply and demand was an important causal fulcrum) version that is functionally indistinguishable. CB balances in "simple" Woodford may be thought of as an MOE but their MOE-ness is not scarce, there are no yield spreads. And if they are also never expected to be scarce again (there is no convenience yield discounted the price level at all), then it really doesn't matter that he didn't go fully monty and eliminate the MOE.

What he retained was the MOA and so his model is still not moneyless, even if it is or can be described as cashless. And the only reason we know you can't also get rid of the MOA in some more complicated version as we did the MOE is because sticky prices are still key to the NK model and sticky prices can't exist without an MOA and a price level. But he was very vague about the importance of the MOA in his story, which is maybe in part why so many people still think of the NK as just another RBC model in disguise. It's too easy to turn the NK into an RBC model by replacing sticky prices with some other friction.

I actually don't see much to like in the NK model overall, but I nonetheless agree with what Woodford said at the end of his '97 paper which is directly relevant to why I'm not a big fan of the focus suggested in this thread:

Analysis of the cashless limit also makes it clear that improvements in the
efficiency of financial arrangements, that reduce or destabilize the demand for the monetary
base, need not be a source of macroeconomic instability. Once one specifies monetary policy
in a way that makes the cashless limit well-behaved, it becomes possible to separate the
problems of the desirable regulation of the payments system and of the desirable conduct of
monetary policy

Vladimir, I think you're confusing market price with value of assets, which has to be kept distinct when discussing what the central bank is going to do to halt the run.

When depositors scramble to withdraw their funds, the assets that the banks (whether real or shadow) are forced to sell may not have changed in economic value at all. But their market price will be falling in the panic. This is what the "solvent but illiquid" verbiage is trying to express. During the crisis, it was not just truly insolvent parties whose assets were really worth less than their liabilities that got into trouble -- even solvent entities had a crisis, because the market value of their assets was far below their economic value.

I know that runs only happen with maturity-mismatched entities. Where I disagree with advocates of "full-reserve" banking is in whether it is possible or desirable to eliminate this maturity mismatch from the system.

I would deny that this talk about "value" as distinct from price is meaningful in this context. Ultimately it's used to obscure the true nature of the business, and to present a government bailout of insolvent parties as something else. (Mind you, here I'm not making any general argument either for or against such bailouts -- only that things should be called by their proper names, not obscured by abuse of terminology.)

Re: maturity mismatching, without getting into the debate about full-reserve banking, one should note the contrast between maturity transformation through debt and analogous operations financed by equity. This is something often overlooked in these discussions: people write as if the danger of Diamond-Dybvig runs is an inevitable feature of a financial system that's capable of financing long-term projects with the money of people who don't want to deposit it for an equally long term. Whereas in reality, financing them through equity (for example a bond ETF) achieves the same purpose while avoiding the possibility of runs.

And if the payment system freezes up, so that an asset that was once a medium of exchange is no longer a medium of exchange, then we definitely have a problem that fits exactly with my view of recessions.

But still I wonder: is there any sharp dividing line between "short" and "long" assets, where one can run and the other can't, or is it just a difference in degree? Looking at my diagram, if I slowly twisted the reaction function clockwise (as the asset got longer and longer) there would be a point past which there was only one equilibrium.

Does an MOE asset really become a non MOE asset when the payments system freezes? If my bank refuses to hand out savings from my current account, I don't feel like I've been given bank equity in exchange. It's more of an act of, possibly temporary, confiscation, no?

We can finance long-term project with long term "deposits". It's what life insurance companies and pension funds do. And then we force them to mark-to-market and evaluate pension funds managers on a quarterly,even monthly basis. We create market instability out of thin air.

Vladimir, you're denying then that any such phenomenon as a bank run exists. The entire point of the theory of bank runs is trying to explain situations where assets have value greater than what they can be liquidated for.

Financing through equity does not achieve the same purpose, not even close. Investors who don't want to deposit their money for the long term are not investors who want to deposit their money for the infinitely long term that is equity. Equity financing does not involve maturity transformation, and maturity transformation is essential in a world where assets are long-term and a large portion of wealth is held by investors who don't want to invest for the long term.